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Sunday, March 24, 2019

Modern Monetary Theory and the Unspoken Effects of Inflation

If inflation leads to such negative consequences, then why do so many economists think inflation is necessary?

Image Credit: Geralt from Pixabay

There has been plenty of discussion recently on what Modern Monetary Theory (MMT) is and the negative effects this policy can have on the economy. MMT supporters argue that the government is not constrained by how much it can tax. They argue that the government can simply print more money to finance deficits. In essence, MMT supporters are arguing for the government to create monetary inflation (an increase in the supply of money).

Some of them recognize that this can lead to price inflation (higher prices as measured by the Consumer Price Index) but argue that as long as inflation is low, there should be no problems with the government financing deficits by printing money. Yet MMT supporters and many mainstream economists ignore or are not aware of two important effects of price inflation on the economy.

Price Inflation Affects Different People Differently

Since price inflation is caused by an increase in the money supply (money printing)—and according to MMT supporters, government should use the new money printed to fund deficits—then by definition this new money will not be distributed to everyone equally or in equal proportion with their current income. This means that some people will be able to use the “new money” before prices have risen, and as a consequence, will benefit more than others. Henry Hazlitt explains this very well in his book Economics in One Lesson. In his chapter “The Mirage of Inflation,” Hazlitt writes:

This [the increase in nominal income as a consequence of the newly-printed money] does not mean, however, that everyone’s relative or absolute wealth and income will remain the same as before. On the contrary, the process of inflation is certain to affect the fortunes of one group differently from those of another. The first groups to receive additional money will benefit the most. The money incomes of group A, for example, will have increased before prices have increased, so that they will be able to buy almost a proportionate increase in goods.

The money incomes of group B will advance later when prices have already increased somewhat, but group B will also be better off in terms of goods. Meanwhile, however, the groups that have still had no advance whatever in their money incomes will find themselves compelled to pay higher prices for the things they buy, which means that they will be obliged to get along on a lower standard of living than before.

In addition to this, it should be noted that price inflation as measured by the Consumer Price Index (CPI) does not capture how price increases affect everyone. CPI measures how much prices change on average since it is based on an average basket of goods and services. For instance, food in the CPI calculation accounts for about 13 percent of the basket. But not all Americans spend 13 percent on food.

People with low incomes spend more than 13 percent, and those with more income spend much less than this. One cannot expect Jeff Bezos and a retiree to spend the same portion of their income on food. This means that inflation is different for different groups of people, and this is another way we can see how different groups of people are affected differently by it.

Inflation Distorts the Structure of the Economy 

This may be hard to understand for those who subscribe to MMT (and Keynesians in general) since, for them, all that matters is aggregate demand (the total amount of goods and services demanded). Yet, since inflation comes from an increase in the supply of money, it affects different industries differently. The new money that is printed will not be distributed equally to all industries. Instead, it will go first to some industries and later to others. As Hazlitt states in “The Mirage of Inflation”:  

Even a relatively mild inflation distorts the structure of production. It leads to the overexpansion of some industries at the expense of others. This involves a misapplication and waste of capital. When the inflation collapses, or is brought to a halt, the misdirected capital investment—whether in the form of machines, factories, or office buildings—cannot yield an adequate return and loses the greater part of its value.

This is exactly what happened during the housing bubble. After the 2001 recession, the Fed increased the money supply in order to lower interest rates and “stimulate the economy.” This led to an overexpansion of the housing industry. Now, since resources were limited, this new money started to lead to higher prices, at which point the Fed interfered by increasing their target interest rates (the federal funds rate).

At this point, it became apparent that many people had made bad investments and that what was happening was unsustainable. It should also be noted here that it is not clear where the “new money” will go; this depends on the market conditions (including government regulations) at the time the “new money” is printed.

Why Do MMTers and Mainstream Economists Like Inflation?

If inflation leads to such consequences, then why do so many economists think inflation is necessary? First, most economists do not see the effects of inflation as described above. In mainstream economics, inflation is assumed to be neutral, meaning it only affects nominal income (incomes not adjusted for inflation) and does not affect real incomes. Because of this, these economists do not see any of the effects of inflation described above as problematic. In fact, they do not even recognize these problems. Everyone who has seen a textbook on inflation knows this.

Now, to be fair, most of these economists see that some people can benefit and others will lose, but this is not for the reason explained above. On the other hand, most mainstream textbooks completely ignore the destructive effects of inflation in the structure of production. They do not believe inflation can change the structure of production, but as it is explained above, this is inevitable.

Regardless of what the reasons in favor of inflation are, we must not ignore the disastrous effects it has on the economy.

Second, while most mainstream economists have expressed concerns about MMT, they agree with MMT supporters that some inflation is important for a healthy economy. The argument here is that inflation makes it less expensive to borrow, which will lead to more investments. Deflation, these economists argue, is destructive to the economy because it makes it harder for borrowers to repay their loans since the prices of their products decrease. Yet businessmen do not need inflation to help pay for their loans.

All they need is to be able to estimate the cost of production (including repaying loans) and the revenue they will receive. In addition to this, most economists today believe there exists an inverse relationship between inflation and unemployment. That is to say, they believe inflation can help lower unemployment. This is known as the Philips Curve, and not everyone agrees that this relationship exists or that inflation causes unemployment to decrease (here is an article discussing this). Regardless of what the reasons in favor of inflation are, we must not ignore the disastrous effects it has on the economy.

  • Dr. Klajdi Bregu is an assistant professor of economics at IU South Bend’s Judd Leighton School of Business and Economics. Prior to his appointment to the Leighton School faculty, Dr. Bregu taught at the University of Arkansas. He has published research in the Journal of Economic Dynamics and Control and the Southern Economic Journal. He is also a fellow at the Center for Market Research.